BoE says UK to shrink sharply, signals rate cuts

(Refiles to add dropped word "cuts" in first paragraph

LONDON (Reuters) - The British economy will shrink sharply next year and inflation could fall to just below 1 percent in two years, the Bank of England predicted on Wednesday, suggesting further interest rate cuts to come.

In its gloomiest set of forecasts in more than a decade, the central bank said the British economy had probably already entered recession and was likely to contract further through next year.

The BoE's charts show CPI inflation, currently running at 5.2 percent, falling to just below 1 percent, half the central bank's target, in two years assuming interest rates stay at their current 3 percent or even if they fall in line with the path implied by market rates before last week's shock rate cut.

Since last week's 1.5 percentage point rate cut, markets are now expecting interest rates to come down more sharply, and even perhaps below 2 percent.

"Since August, the world has changed, we have changed our forecasts," BoE Governor Mervyn King told a news conference.

"We are certainly prepared to cut Bank rate again if that proves to be necessary. There are many things to learn between now and our next meeting," he said.

The pound tumbled in response to the Bank's quarterly inflation report.

Sterling extended earlier falls after the report's release, hitting a record low versus the euro at 82.15 pence, while the pound also hit a six-year trough at $1.5255

Interest rate futures extended gains, rising to trade as much as 15 ticks higher on the day across the strip.

"November's Inflation Report gives a very strong indication that the Monetary Policy Committee expects to cut interest rates much further over the coming months," said Jonathan Loynes, economist at Capital Economics. "One percent (or below) here we come."

(Reporting by Sumeet Desai and Christina Fincher, editing by Mike Peacock)